f1 - economics april 2007

8/14/2019 F1 - Economics April 2007

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NOTESAnswer four questions,

question I which is compulsory

and any 3 other questions.

TIME ALLOWED:3 hours, plus 10 minutes to read the paper.

INSTRUCTIONS:During the reading time you may write notes on the examination paper but you may not commence

writing in your answer book.

Marks for each question are shown. The pass mark required is 50% in total over the whole paper.

Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills

and care must be taken regarding the format and literacy of the solutions. The marking system will take

into account the content of the candidates' answers and the extent to which answers are supported with

relevant legislation, case law or examples where appropriate.

ECONOMICS &

THE BUSINESS ENVIRONMENTFORMATION 1 EXAMINATION - APRIL 2007

The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.


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THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

ECONOMICS &THE BUSINESS ENVIRONMENT

FORMATION I EXAMINATION APRIL 2007

Time allowed: 3 hours, plus 10 minutes to read the paper. Answer 4 questions, question 1 which is compulsoryand any 3 other questions.

Question 1 is allocated 40 marks and eachof the other questions are allocated 20 marks.

1. Write a note on four of the following:(i) The characteristics of Economic Goods.(ii) Economic Rent.(iii) The factors that determine (or influence) Price Elasticity of Demand for a good (or service)

(iv) Fiscal Drag.(v) Formal and the Impact Incidence of a tax.[40 Marks]

2. (a) What is meant by long run equilibrium as the phrase is used in relation to a firm that seeks to earnas much profit as possible. e.g. a profit maximising firm at long run equilibrium.

(4 marks)

(b) Under what conditions (or circumstances) would a profit maximising firm be at long run equilibrium?(6 marks)

(c) An Irish firm that seeks to earn as much profit as possible is competing against firms from other Eurozone countries in a market that is perfectly competitive. If the Irish firm is at long run equilibriumexplain how the Irish entrepreneur is likely to react to each of the following eventualities:(i) there is a general round of wage increases in Ireland;(ii) there is an increase in the world price of oil.

(10 marks)

[Total: 20 Marks]

3. (a) Is economic growth desirable? Explain your answer.(8 marks)

(b) What is meant by sustainable economic growth?(4 marks)

(c) Is it possible for the Irish economy to have continuing growth rates of (say) 7% per annum? Justifyyour answer.

(8 marks)

[Total: 20 Marks]

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4. (a) From the following information calculate (i) the level of GNP in period 2 (ii) the Multiplier (iii) themarginal propensity to import (MPM) and (iv) the marginal propensity to save (MPS). (For thepurpose of this question we are not including the government sector)

(12 marks)

(b) State, giving reasons, if you would expect the value (and/or volume) of imports to increase if there isan increase in value (and/or volume) of exports.

(8 marks)

[Total: 20 Marks]

5. (a) What actions might an economic independent government take if it wished to increase the level ofaggregate demand in the economy? (Ireland before we joined EMU or currently the UK governmentare examples of economically independent governments).

or

Explain the policy instruments available to an economically independent government that seeks to regulatethe macro economy.

(10 marks)

(b) Explain how joining the European Union and EMU has affected the Irish government in its efforts toregulate the Irish economy.

(10 marks)

[Total: 20 Marks]

END OF PAPER

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Private GNP CONSUMPTION INVESTMENT EXPORTS IMPORTS

PERIOD 1 23800 17000 6000 3000 2200

PERIOD 2 18200 6300 3400 2400


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ECONOMICS &THE BUSINESS ENVIRONMENT

FORMATION I EXAMINATION MAY 2007

SOLUTION 1.

The format and nature of this question is to acquire an indication of the students overall understanding ofthe subject. It not only permits the exam paper to reflect more accurately the comprehensive nature of thesyllabus but also increases the opportunity for students to obtain full reward for their studies. The topicschosen for the elements of this question are fairly precise and have links with the syllabi of various othersubjects including taxation, advanced taxation, management accounting strategic management accounting& management and strategy. The pattern to date has been that the level of answering in this question hasbeen a good predictor of the overall performance of students.

(i) In the study of economics we are concerned with goods which are capable of being bought and sold, suchgoods are known as economic goods and their characteristics are:

G Utility. Utility refers to the ability of a good to give satisfaction or satisfy a need or want, it is this abilitywhich renders goods desirable. Thus since goods must be desirable if they are to be bought it is acharacteristic of economic goods that they possess utility. It would be futile to attempt to sellsomething which is a nuisance or irritant and has no utility.

G Scarcity. Economic goods are scarce in relation to the demand for them. The concept of scarcity asused here means that there is not enough of the good to satisfy the demand of all those who want it;this is why people must pay a price in order to acquire it. Thus in this country fresh air would not bean economic good because even though it provides utility it is not scarce in relation to the demand

for it.G Transferable. Economic goods must be capable of being passed from one person to another i.e. theymust be transferable. People are unable to sell what they cannot pass to the buyer and people won'tbuy what they cannot receive or control. It is because they do not satisfy this criterion of transferabilitythat good health, pleasant disposition, beauty and intelligence are not economic goods even thoughthey satisfy the first two criteria of possessing utility and are scarce in relation to the demand for themin the sense that not everybody has them though all desire them.

(ii) The supply price of a factor of production is the sum of money which must be paid in order to acquire theuse of that factor. Economic Rent is any payment to a factor of production in excess of its supply price.The supply price of the factor of production labour is the transfer earnings of the factor i.e. the payment (ornet benefits) which it can earn in the next best situation available so that if a firm employs an electrician at

a wage of 600 and the transfer earnings of the electrician is 480 then in this instance the electricianwould enjoy an Economic Rent of 120.To the extent that workers would be willing, if necessary, to continueworking in their present jobs even if their wages were reduced then they are certainly earning someEconomic Rent. In general, the existence of Economic Rent may also be deduced if workers of similarability are employed elsewhere in comparable work and these workers would be willing to transfer from theirpresent employment to the job in question. One of the reasons why workers might enjoy an Economic Rentcould be due to the existence of a trade union in the particular job.Since Economic Rent is a payment in excess of the supply price i.e. in excess of the transfer earnings of afactor, then the more narrowly defined the occupation the lower will be the Economic Rent. For example ifthe occupation of a person is "a CPA in firm A" then his/her Economic Rent may be close to zero sincehe/she might be able to earn virtually the same salary as "a CPA in firm B". However if the individual'soccupation is defined within the firm as "an accountant" then the next best job available to him/her may be

as a general clerk with considerably lower earnings, in which case there would be an element of EconomicRent in the payment that s/he receives in the position that is classified as an accountant Rent. In relationto entrepreneurs Normal Profit is considered to be the supply price of entrepreneurs so any payment inexcess of this supply price viz: Supernormal Profit would be considered a form of Economic Rent.

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(iii) Price elasticity of demand refers to the sensitivity of demand for a good in response to a change in its ownprice. The factors which affect price elasticity include the following.

G The availability of close substitutes at competitive prices is the greatest single influence on priceelasticity of demand. Goods are purchased because they provide utility, if there are other goodsavailable at comparable prices which provide more or less the same utility consumers will switch tobuying these substitute goods if the price of the good in question is increased more than the price ofsubstitute goods. Similarly if the price of a good is reduced relative to the price of substitute goods theconsuming public will switch to buying the good which has become relatively cheaper. The closer thedegree of substitutability the more will consumers tend to switch their purchasing behaviour inresponse to a change in relative prices and consequently the greater will be price elasticity.

G If the good in question is one of two goods which are in joint demand then this complementarity affectsprice elasticity of demand for the good. Reductions in the price of complementary goods will increasethe demand for the good in question e.g. a reduction in the price of motorcars will increase thedemand for petrol. If the good in question is the cheaper of two goods which are in joint demand, thenthe demand for it is likely to be relatively inelastic in response to changes in its own price.

G The proportion of income which is spent on the commodity also affects it elasticity. In general thegreater the proportion of a person's income which is spent on a good the greater will be that person'sprice elasticity of demand for the good. The reason for this is that the greater the proportion of yourincome which you spend on the goods the more significant to you is a change in its price.

G

The more durable the commodity the more elastic is the demand for it likely to be in response tochanges in its own price. This is because it is easier the postpone the purchase of such goods byextending the life of the existing model. Examples of such goods are refrigerators, bicycles,lawnmowers.

G The expectations of consumers as to future price changes will affect elasticity. No matter what ishappening in respect of current prices if consumers expect prices to be lower in the future they willrefrain from buying in the present conversely they will bring forward their purchasing if they expectprices to be even higher in the future.

(iv) Fiscal policy refers to any conscious action by the government in relation to the magnitude, structure ortiming of government revenue or expenditure. Fiscal drag is the term which can be applied when the effect

of fiscal policy is to reduce the level of aggregate demand below what it would be in the absence of the fiscalpolicy. However, the use of the term is more usually reserved for occasions attributable to the coming intooperation of the downward aspect of automatic stabilisation at a stage when the economy is operating belowthe desired, or targeted, level. Whenever the government budgets for a surplus it is in effect deflating theeconomy but such action is not normally referred to as fiscal drag since when budgeting for a surplus theintention of the budget strategy is that purchasing power will be taken out of the economy. The term fiscalstrategy tends to be reserved for situations where the effect of fiscal policy is to deflate the economy in amanner or to an extent which was not intended, an occurrence of this nature usually is attributable to theeconomy being more buoyant than was envisaged at budget time so that tax revenues are greater thananticipated. If this situation develops when the economy is at less than full employment then the effect offiscal policy is lessen the degree of economic activity, at least in the short term, until discretionary fiscalpolicy may be implemented. Government tax revenue is predicated on some forecast level of economic

growth, for any given rates of taxation, tax revenue will be greater than anticipated when the rate of growthin the economy exceeds forecasts. In such a circumstance the withdrawal of purchasing power in theeconomy through taxation will be greater than intended and since increases in the level of discretionarygovernment expenditure takes time to implement the net effect is a withdrawal of purchasing power from,and a consequent reduction in the level of, aggregate demand. It is this form of occurrence that is referredto as fiscal drag.

(v) The incidence of a tax refers to the manner in which the burden of the tax is borne. A distinction can bedrawn between the formal incidence of the tax which means the person or commodity on which the taxwas levied, and the effective incidence of the tax which means who actually pays the tax e.g. a tax onbuilders may result in an increase in the price of houses by the amount of the taxes, in which case, thoughthe formal incidence of the tax would have been of builders the effective incidence of the tax is on

purchasers of the properties. This concept is relevant also in a slightly different context which recently hitnewspaper headlines when they reported government statements that there was a likelihood that anyreduction in stamp duty on houses which was intended to benefit purchasers of houses would end up in the

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pockets of builders, if as anticipited the price of houses would be increased to reflect any reduction in stampduty. With respect to direct taxes it is rather difficult to shift the incidence of such taxes e.g. if I am paid 400per week and I had been paying 60 per week income tax, if my income tax liability is increased to 70 perweek it is extremely unlikely that I will be able to negotiate a wage increase of 10 in order that I maymaintain parity in my after-tax pay. In contrast to this situation in respect of direct taxes such as income taxit may be possible for a retailer to shift forward on to customers or 'backwards' on to manufactures all, orsome of, the incidence of an expenditure or excise tax. Whether or not this is possible depends on therelative elasticities of supply and demand for the product on which the tax is levied. Whichever of supply ordemand is the more inelastic will tend to end up bearing the greater proportion of the tax and if for exampledemand was perfectly inelastic then it would be possible to increase the price of the good by the full amountof the tax without there being any resultant fall-off in demand.

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SOLUTION 2.This question is drawn from information set out in sections 1 and 2 of the syllabus; part (c) of the question

depicts a situation encountered by Irish exporting firms. The area of the syllabus being tested is

complementary to topics developed in management accounting and strategic management accounting.

(a) Long run equilibrium means that in a time period sufficiently long to enable a firm to adjust to marketconditions that it is performing in a manner that achieves, or gets as close as it can to achieving, itsobjective(s). In relation to a firm which is pursuing a profit maximisation objective it means that underexsisting market condition it is not possible for the firm to earn a higher level of profit by changing either itslevel of output or its selling price. Thus there is no incentive for this firm to change its selling price or levelof production unless there is some change in market conditions.

(b) A profit maximising firm would be at long run equilibrium under the following conditions:

(i) producing a level of output at which marginal cost is equal to marginal revenue.

(ii) subject to the condition that when producing the level of output set out in (i) above marginal cost isincreasing at a faster rate than is marginal revenue.

(iii) the firm must be earning at least Normal Profit.

(c) (i) A profit maximising firm at long run equilibrium in a perfectly competitive market would be earningNormal Profit. If there was a general round of wage increases in Ireland and such a wage increasewas not being experienced by the foreign competitors then since the Irish firm acting on its own is notin a position to influence market prices then this increase in costs would result in the firm earning lessthan Normal Profit and thus it would be forced to leave the industry in the long run. If in the short runthe revenue of the firm was in excess of its variable costs then it would stay in the industry in the shortterm and exit in the long run.

(ii) If all firms in the industry suffered the same increase in world oil prices and assuming that thisimpacted to the same extent on all the firms then the increase could be passed on to the consumersthrough increased selling prices.

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SOLUTION 3.

Information set out in sections 5 and 6 of the syllabus is being sought in this question. Knowledge acquiredin this section of the course will provide a basis for further analysis of this and related topics in strategicmanagement and management and strategy.

(a) Economic growth is desirable to extent that there are benefits attaching thereto. Economic growth ismeasured by the increase in the quantity of goods and services available to us. Thus the principal reasonfor pursuing economic growth is because it improves the general standard of living. Economic growthprovides the resources for investment and also incentives to invest. Through increased economic growth itis possible to alleviate poverty and it is easier to gain acceptance for such redistributive policies when thegeneral standard of living is rising. In addition economies of scale are possible in activities undertaken bythe government so that during a period of economic growth government expenditure as a proportion of GDPshould fall. There are costs associated with economic growth as can be seen in the Irish economy atpresent. Examples of these costs are infrastructural pressures, pollution, misdistribution of the benefits ofeconomic growth and the threat of inflationary pressures.

(b) Sustainable economic growth means that it is possible for the economy to continue to grow in future periodsat the rate that is currently being experienced on that current rate of Economic growth will not inhibit thefuture rate of Economic growth.

(c) If an economy is not operating at full employment then, depending on the degree of underutilisation ofeconomic resources or current technological best practices it is possible for the economy to grow at aspectacular rate in a form of catching-up exercise. However once an economy is at a developed stage andoperating at full employment then future rates of growth are depending on capital deepening, more skilledwork force and the possibility of an increasingly immigrant work force. Significant increases in the populationof the country also impose pressures on the economic and social infrastructure so that continuing increasesin economic growth at rates of 7% become increasingly less likely.

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SOLUTION 4.

This question which relates to sections 5 and sections 8 of the syllabus illustrate in a quantified way theinterrelationships between different sectors of the economy. This approach will assist the student inrecognising precise linkages within the economic and business environment and will be of benefit whenstudying the content of the management and strategy course.

(a) (i) Level of Income (Y) = Consumption + Investment + (Exports Imports).

= 18050 + 6300 + (3400 2550)= 18050 + 6300 + 850.= 25200.

(ii) From period1 to period 2 injections increased by 700 (an increase of 300 in respect of investmentand an increase of 400 in respect of exports). As a result of this increase of 700 in injections GDPincreased by 1400 (from 23800 to 25200) therefore the multiplier is 2.

(iii) When income increased by 1400 imports increased by 350 therefore the Marginal Propensityto Import (MPM) is equal to 350/1400 = 0.25.

(iv) When income increased by 1400 consumption increased by 1050 so that the Marginal Propensityto Consume (MPC) is 1050/1400 = 0.75. Since the Marginal Propensity to Save is defined as 1 MPCtherefore the Marginal Propensity to Save is equal to 0.25.

(b) As shown in the above example when there is an increase in the level of exports there is an increase in thelevel of injections into the economy. The extent to which an increase in exports increases the level of incomein the economy depends not only on the magnitude of the increase in exports itself but also on themagnitude of the multiplier. Thus when exports increase purchasing power within the economy increasesand in the course of spending this additional income there emerges an increase in demand for importedgoods and services. In addition to purchasing additional imported goods and services consumers alsospend some of their additional money on indigenous goods and services and as many of these goods useimported raw materials this is another source of increased demand for exports. Given the importance of oil

products in the conduct of economic life any increase in wealth within the economy will result in a direct andindirect increase in demand for this imported product.

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SOLUTION 5.

The material for this topic is contained in sections 6 & 8 of the syllabus. It has links with the legal frameworksyllabus and also is complementary to aspects of the strategic management course. Exam questions basedon new circumstances arising from the shift of macroeconomic decision making to European institutionshelp to develop students understanding of the changed and changing business environment that applies toIrish firms and institutions.

(a) The policy instruments available to an economically independent government are Monetary Policy,Exchange Rate Policy and Fiscal Policy. It is generally accepted that it is not possible to consider monetarypolicy and exchange rate policy as two distinct objectives. The level of interest rates within a jurisdictionaffects both the level of economic activity and the external value of the currency so that if interest rates arebeing used as a tool for regulating the level of domestic demand they it is not available as a discretionarytool for the influencing the external value of the currency. However, there is a convention in text books todiscuss each of them separately.In terms of monetary policy if the authorities wish to stimulate the economy policies could be directedtowards lowering interest rates and increasing the money supply. In terms of exchange rate policy if therehad been a fixed exchange rate policy in place a decision might be made to devalue the currencyalternatively a policy of benign neglect could be adopted whereby the authorities take no action in the factof a downward float in the foreign exchange value of the currency. In terms of fiscal policy an expansionary

fiscal policy in conducted through budget deficits.A reversal of each of the above polices would be the appropriate action if the wish was to deflate theeconomy in such circumstances increased interest rates, currency appreciation and budget surpluses wouldbe the order of the day.

(b) Ireland and the other member states have sacrificed some economic sovereignty upon joining the EuropeanUnion and European Monetary Union. Monetary policy for the Euro zone is within the jurisdiction of theEuropean Central Bank. Thus the level of interest rates that apply within the Irish economy are set by theECB and are not at the discretion of the Irish authorities except in so far as we are members of the decisionmaking board within the European system of Central Banks. In contrast to the approach adopted by the Irishauthorities which would be determined by what is best for the Irish economy the ECB will base its decisionmaking on what is appropriate for the Euro zone in general rather than concentrating on what is in the best

interest of any individual member state. Even more obvious is the inability of the Irish authorities by theirown actions to influence the foreign exchange value of the Euro currency. Despite our membership ofEuropean Monetary Union the Irish authorities still have some control over fiscal policy; it is still possible tostimulate the economy by an expansionary fiscal policy. However, there is a constraint on this discretionsince under the terms of the Stability & Growth Pact budget deficits should not be greater than 3% of GDP.However, since tax harmonisation is not a feature of European Monetary Union the Irish government hasdiscretion over the manner in which it imposes its taxes.

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ECONOMICS &THE BUSINESS ENVIRONMENT.MARKING SCHEME--- May 2007

Q1. 10 marks for each of 4 satisfactory answers. 40 marks

Q.2. (a) An adequate definition 4 marks

(b) 3 conditions @ 2 marks each 6 marks

(c) Reaction to each devloment @ 5 marks 10 marks

Q.3 (a) 4 aspects of economic growth @ 2 marks each 8 marks

(b) An adequate explanation 4 marks

(c) 2 relevant considerastions @ 4 marks each 8 marks

Q.4. (a) 4 parts to the question @ 3 marks each. 12 marks

(b) 2 reasons @ 4 marks each. 8 marks

Q.5. (a) 1 policy instrument @ 4 marks & 2 @ 3 marks each. 10 marks

(b) Restriction on fiscal policy @ 4 marks.

Non-availability of other 2 instruments @ 3 marks each 10 marks

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f1 - economics april 2007

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